William Davidson Institute Working Paper 402
Kong, Bulgaria and Estonia), in general as a solution of last resort to excessive price
and financial instability. Under a currency board, a fixed conversion rate between the
local currency and a foreign one is decided and the domestic monetary base (cash and
bank deposits) is 100% (and more) backed by low risk assets denominated in the
foreign currency. The currency board has no right to issue central bank money against
any domestic assets.3
In general, currency boards have contributed to bring down high inflation
quite fast, but recorded less impressive results in terms of stabilising output in the
aftermath of major adverse shocks (Chang and Velasco, 2000). The major difficulties
faced by Argentina after the 1998 crisis until today (July 2001) point at the main risks
associated to currency boards. Pegging the peso to the dollar helped Argentina to
bring down inflation sharply. The reverse of the medal comes with dollar appreciation
at the end of the nineties. This deteriorated strongly Argentinean competitivity on
Latin American markets, in particular with respect to Brazil, its main competitor.
With falling exports, despite the slow growth recorded in 1999 and 2000, the trade
deficit increased and required increasing external financing. Although devaluation did
not seem possible, investors become increasingly nervous about the possibility of the
Argentinean government to service its debt. In June 2001, the government, supported
by the IMF, managed to convert some short term into long-term debt, and by July, the
peg to the dollar was partly relaxed (exporters get a subsidy, while importer pay a
tax); it is also planned to use as reference money a synthetic currency, composed of
dollars and euros. But the risk of liquidity has not yet disappeared. As an upshot,
Argentinean experience emphasises that a small country takes major risks from
pegging its currency to a country which is not its dominant trading partner, even if
devaluation is not an option.
Bulgaria adopted an idiosyncratic4 currency board in July 1997 as the main
building block of a resolute stabilisation programme. Inflation fell dramatically, from
580% in 1997 to less than 1% in 1998. Although the growth rate was of some 3% per
year during the period 1998-2000, the unemployment rate has kept on increasing, to
reach 18% in 2000.5 Another major risk for Bulgaria is related to the large and
increasing foreign debt.
Guide, Kahkonen and Keller (2000) point that by ruling out the possibility to
finance the deficit by money creation (that is, no central money can be issued against
treasury bonds), a currency board would set a strong constraint on spendthrift
governments and would bring about more fiscal discipline6. This argument applies as
such for closed economies, but less so in a global environment, according to the
famous Mundell-Fleming paradigm.
Let us consider two identical countries, with the same initial fiscal stance and
the same risk of default on the sovereign debt. One country has a currency board, the
other a central bank under a fixed exchange rate mechanism. We assume that under a
currency board the devaluation risk is zero (but the rationale would not change if we
3 Under dollarization, the country loses the seigniorage income, but the credibility of the fixed parity is
much increased, given the very high costs of reversing the process.
4 The Bulgarian monetary institution lacks an important feature of basic currency boards. The
government account is held at the Currency Board. In case of a deficit, this would lead automatically to
an increase in the monetary base. See Miller (1999).
5 By not underestimating the size of unemployment, this should not necessarily be seen as a signal of
poor performance: the impossibility of the central bank to lend to the government has limited the
spending possibilities of the government and, thus, put an end to state subsidies to under-performing
firms. In turn, this may have pushed with much needed restructuring.
6 But not necessarily financial discipline in the economy, where firms may continue to run big arrears.